What is Mezzanine Financing?
Mezzanine financing in commercial real estate authorizes a lender to convert their debt into equity in the event that a borrower defaults. For example, if the borrower fails to pay the debt in a timely manner, the lender has the right to take action by taking a portion of the investment property and then selling it to pay off that debt. Mezzanine financing can be beneficial for both first-time commercial real estate property investors, but can also be ideal for those investors who are looking to expand their property, but do not have enough funds. Mezzanine loans typically have 1-5-year terms, though some may go up to 10. In addition, many mezzanine loans are interest-only.
The Benefits and Drawbacks of Mezzanine Debt
One of the advantages of a mezzanine debt is the ability for flexible financing, as well as the low probability that an owner will lose ownership or control of a property. Mezzanine financing also does not typically require a lot of due diligence, so it may be able to close more quickly than other types of loans. However, compared to a senior debt, a mezzanine debt is riskier due to a lack of collateral from the borrower. Therefore, interest rates tends to be higher, often between 10-20%, and more covenants are included. Common convenants might include restrictions on taking cash out of the property as well as a prohibition on obtaining additional financing until the mezzanine loan has been repaid. Mezzanine lenders are usually granted a lien against the entity that owns the property
Adding Mezzanine Debt to The Capital Stack
In today’s world, mezzanine debt is often used on top of a traditional, first-position commercial real estate loan (often a bank loan), but sometimes a CMBS loan, in order to increase leverage and reduce the amount of cash needed at closing. For example, a first position bank loan may reach 70% LTV, while a borrower takes out a mezzanine loan for another 20% of the property cost, bringing the overall LTV to 90%.
Currently, even some agency lenders, such as Freddie Mac, have introduced mezzanine financing products in order to help encourage borrowers to keep properties affordable, and, while Fannie Mae does not have its own mezzanine product, it does allow borrowers to use mezzanine debt in a variety of situations. In general, a first position lender will require an intercreditor agreement between them and the mezzanine lender in order to establish the borrower’s order of repayment, as well as defining each lender’s rights and responsibilities involving their shared relationship with the borrower.
Most major CRE lenders require a borrower to hold their property in bankruptcy-remote special purpose entity (SPE), but this is especially a priority for mezzanine lenders, who want to ensure that they will be paid back, even if the borrower declares bankruptcy. Thus, intercreditor agreement will usually involve the mezzanine lender being pledged 100% of the shares of the SPE as collateral. In some cases, the special purpose entity will even have an independent director in order to reduce the chance that the borrower will try to file for bankruptcy.
Mezzanine Loan Prepayment Penalties
Like most other kinds of commercial real estate debt, mezzanine debt usually involves a prepayment penalty if a borrower attempts to pay off their loan early. While mezzanine loans do not typically have long lock-out periods, prepayment may still be expensive, as lenders typically require borrowers to pay yield maintenance, which allows the investors to '“maintain” the exact same yield they would if the borrower had not prepaid the loan.
Mezzanine Financing vs. Preferred Equity
For commercial real estate developers who need more funds to build or purchase a project, preferred equity is becoming an increasingly popular alternative to mezzanine financing. Unlike mezzanine financing, which is debt with an equity conversion option, preferred equity grants the outside investor direct equity in the project itself. In general, preferred equity gives the outside investor a fixed rate of return.
Unlike mezzanine debt, preferred equity investors do not possess a lien against the entity that holds the property, and, unlike first position lenders, they do not have a lien against the property. For the investor, this makes a preferred equity investment somewhat riskier than a mezzanine loan. However, many preferred equity investors receive what’s called an “equity kicker”, an additional equity incentive that allows them to participate in a project’s upside if it reaches beyond a specific financial hurdle.